Professor Tax

Friday, December 03, 2004

The last posting condensed our review of the literature on the tax compliance behavior of high income people into two paradoxical statements, to which we now add three more:

The Rich don't cheat as much as they should.[According to the economists, that is.]

When the Rich cheat, it's not their fault. [Say the white-collar crime sociologists.]

When the Rich cheat, they cheat honestly.[Says the Law].

The Rich don't cheat -- they have people to do that for them.[Say the accountants.]

The Rich don't need to cheat. [According to the Senate and House of Representatives.]

Let's see what sense, if any, underlies these surprising statements.

1) The classic economic model of tax behavior posits a crowd of rational sociopaths ("taxpayers") who weigh the savings from successful evasion against the expected value of the penalties charged on those occasions when their evasion is detected ("audited"). For example, if some contemplated crooked dodge would reduce tax by $1,000 but have a 20% chance of detection by audit and generate a penalty for evasion equal to 200% of the tax, then the expected benefit from cheating is $800 (80% success x $1,000) and the expected cost is $400 (20% times the additonal $2,000 penalty), so a rational, risk-indifferent taxpayer would go ahead and cheat. More sophisticated models use "utility" (i.e. whatever it is that rational sociopaths try to maximize) instead of dollars, discount to present value, adjust for risk-aversion, introduce uncertainty as to detection probabilities, reflect changes in risk-tolerance and tax rates as a function of increasing income, and so forth.

Fortunately for the US Treasury, in the real world the amount of evasion tends to be much, much smaller than such models would predict, given actual audit probabilities and penalty amounts. For example, of the 130,341,159 individual income tax returns filed in year 2002, only 849,296 ( 0.65%) were examined by the IRS and only 206,457 of these involved face-to-face meetings, as opposed to correspondence generated by computerized data matching programs. Concern over abuse of the Earned Income Credit (a subsidy for the working poor that is implemented thru the income tax system) means that poor people (returns showing income under $25,000) have the *highest* chance of audit. The audit rate for those who are better off -- such as the 2,084,855 returns showing self-employment receipts over $100,000 -- was 1.47%, and these audits resulted in total proposed additional tax of $581 million, not quite enough to pay one day's worth of interest on the National Debt.

While the Tax Code provides a penalty for negligence equal to 20% of the tax, and a 75% penalty for civil tax fraud, these penalties are rarely charged against individual income taxpayers (2,401 penalties in year 2003 equals once per 50,000 tax returns) and the total amount, after abatement for reasonable cause etc., was only $63.4 million -- which someone still has to collect, and which would only cover the cost of running the IRS itself for about two days. In addition, while the prospect of doing hard time may deter the timid, only 384 people -- one taxpayer in 300,000 -- went to jail in year 2003 for tax crimes involving legal source income, and such tax prosecutions cost the government an average of over $100,000 each. To sum up, with an audit probability of 1.5% and the likely punishment simply being made to pay the tax that was due anyway, rationality demands dishonesty. It's a good thing that most people, including most rich people, aren't rational.

A substantial part of the American public seems to believes that the rich don't pay much tax. Professor Slemrod reports one survey where "respondents believed that 45% of millionaires paid no income tax at all, when IRS statistics showed that the actual figure was less than 2%." (1) The public misconception was reinforced by President Bush himself during the recent election campaign when he explained to the assembled rubes:

"The really rich people figure out how to dodge taxes anyway."
"Most rich people are able to avoid taxes, and if you can't raise enough money from taxing the rich, guess who pays the taxes? Yes, you do. "
"The rich hire lawyers and accountants for a reason, to stick you with the tab."

This kind of Presidential nonsense only feeds the cynics. Of course it's not true.

Let's look at the numbers compiled by the IRS Statistics of Income Division. In year 2002 a total of 2,414,127 returns showed adjusted gross income over $200,000. Only 1.86% of all returns were at this income level, but with total income of $1.251 trillion they represented 20.75% of all income. After taking all deductions, 26.4% of all taxable income was on these high-income returns, and their income tax came to $323,977,221,000 -- 40.6% of all income tax that year was on these 2.4 million high-income returns.

"But Professor Tax", you say, "those numbers are for ordinary high income people. What about the real millionaires? What about the 168,977 tax returns that showed income of more than $1,000,000 in year 2002?" Indeed, 0.13% of all returns -- one out of every 770 -- were filed by such folks, who got 7.89% of all the income, 10.34% of all income after deductions, and paid 17% of all the tax, amounting that year to $135,841,970,000. Ouch! No wonder they hate the income tax so much. At the top of the top we've the 5,309 returns showing income over ten million dollars -- 0.0041% or one in every 25,000 -- who had 2.41% of all the income, 2.78% of the taxable income, and paid 4.23% of all the tax. The amount of tax was $33,737,749,000, which works out to an average $6.5 million each. The hand bleeds at the very thought of signing such a check.

This, however, is only what the rich admit to in their tax filings. Maybe there are huge pools of underground cash still hidden from the eyes of the revenuers? Isn't there some substance to all anecdotal evidence about abusive tax shelters and billionaire criminal kingpins?

The IRS' "Audits from Hell", the Taxpayer Compliance Measurement Program in operation between 1969 and 1988, estimated overall income tax compliance at 85% to 90%, which meant a "tax gap" of 10% - 15% between what should have been paid and what actually was paid. An estimate of the components of the tax gap for year 1992 (2) found it was due to:

24 percent - self-employed individuals who do not report all income subject to tax

24 percent - other individuals who do not report all taxable income

19 percent - corporations with assets of $10 million or more that understate their tax liability

9 percent - individuals who do not remit all taxes reported due on their returns

8 percent - individuals who do not file a return

6 percent - individuals who take excessive deductions

6 percent - corporations with assets of less than $10 million that understate their tax liability

4 percent - attributable to other reasons

One study that analyzed data from the last TCMP in 1988 concluded that high income (over $100,000 AGI) returns had a higher rate of voluntary compliance than other returns, and reported over 95% of true income. Returns with income over $500,000 had an even higher compliance rate, reporting over 97% of true income. (3) (Note tho, that this was at a time when the 1986 Tax Reform Act had shut down one generation of tax shelters, and the modern abusive shelters were still taking shape.) And the aging Godfathers and rising capos of the criminal underworld are well advised to reach a truce with the Treasury, since one of the proudest claims in the history of the tax police is still: "We got Capone."